Using LEAPS as Leverage?
In my journey to learn more about personal finance, every time the subject is brought up the message is clear: avoid leverage at all costs. It can quickly ruin you.
“There’s only three ways that a smart person can go broke: liquor, ladies, and leverage.” —Warren Buffett
Recently I came across an interesting 2008 paper that runs counter to that thinking titled Life-Cycle Investing and Leverage: Buying Stock on Margin Can Reduce Retirement Risk. Their argument is that despite the higher risks, adding leverage to portfolio early on has a higher long-term expected return. Younger investors have a longer time horizon to recoup substantial losses and ride out market risks. The higher average expected value of using leverage wins out long-term.
In short, the argument is:
- There is an equity risk premium over the long-term.
- If that’s true, if you have a long time horizon it makes sense to expose yourself 100% to equities to capture the risk premium (all equity portfolio), and even >100% (using leverage).
The two ways they propose implementing leverage are through:
- A margin account
- Buying deep in-the-money call options (LEAPS)
I was curious about the implications of what’s proposed here. Personally since a margin account has potentially unlimited downside, I would never be comfortable using that. But the capped downside aspect of options sounded intriguing. Keep in mind my math might be wrong here, I’m totally new to this.
Using current data, given one call option the ROI becomes positive at around 6%.
Given the historical returns being somewhere around 10%, this seems like not the riskiest bet.
Extrapolating from that, I ran some Monte Carlo simulations comparing the average returns from the S&P500 with the returns generated from the above call option over 20 years.
The blue lines are generated using the same mean & variance of the S&P500, and the red lines are using the leveraged call option from above. It’s immediately clear that the variability of results in the leveraged portfolio is much higher.
Out of thousands of runs, the leveraged portfolio beats the median normal one 80-85% of the time. The normal portfolio falls short of the medidan leveraged one 99% of the time. And around 3-5% of the time the leveraged portfolio has a negative overall return.
The paper itself analyzes 4 model portfolios that include both leveraged and non-leveraged mixes of equities and bonds. Their simulations end up with higher results in the “mean, median, minimum, maximum, 10th, 25th, 75th, and 90th percentiles” for both leveraged portfolios compared to the two normal ones.
So in conclusion, would I base any investment decisions off of one paper and my (likely) faulty math? Probably not. But this is super interesting and I love a paper that goes against conventional wisdom. Leverage still sounds like a good way to shoot yourself in the foot, but this paper convinced me to not be 100% against it.
Update March 2024: Since posting this I’ve done more research into using LEAPS as leverage and have concluded that the volatility drag and tax implications make the strategy likely not worth implementing.